Rising Interest Rates and its Implications for the Future of Technological Innovation
As a designer who works and invests in tech startups, I keep an eye on macroeconomic variables to understand some of the influencing factors of technological innovation.
In the aftermath of the global pandemic, the world witnessed many shifts in economic paradigms. One such notable change has been the rise in interest rates. This article will explore the key causes and implications of this change.
Higher interest rates and the future of innovation
Interest rates, across maturities, have generally been in secular decline since the 1980s but have recently spiked higher.
The rise in interest rates increases the discount rate, which erodes the present value of future cash flows, impacting investment decisions.
Projects that promise large payoffs further in the future may appear less attractive because discounting future earnings to the present at a higher rate decreases their value.
Since the 1980s, interest rates have been in a secular decline, increasing the likelihood of investment in speculative technology ventures with returns far into the future.
Below are some significant technological innovations since the 1980s that benefited from declining interest rates, making capital more readily available for investment.
Personal Computers — 1980s
The personal computer revolutionized home and business computing. Easy access to capital allowed companies like Apple and IBM to invest in developing and producing personal computers.
Internet and Web Services — 1990s
Easy access to capital fueled the dot-com boom. Companies like Amazon and Google started and transformed retail and information access.
Social Media Platforms—2000s
Social media platforms reshaped how we interact and consume information. Lower capital costs spurred investment in these platforms.
Smartphone and App Economy—2010s
The proliferation of smartphones has dramatically changed many industries. Companies like Apple and Uber have greatly benefited from easy access to capital.
Artificial Intelligence and Machine Learning—2020s
AI and machine learning are the frontiers of current technological innovation. Lower interest rates have facilitated significant investment in these areas.
As interest rates rise, future technological innovations could diminish. These innovations consequentially reduce future inflation by making the economy more productive. Less innovation could translate into higher inflation, increasing interest rates and reducing the appetite to fund innovation in a deleterious cycle.
Less investment in innovation also translates into fewer employment opportunities for designers, product managers, and engineers.
Interest Rate Rise
The Federal Reserve initially thought inflation was transitory as it started to break out in 2021 and kept the Federal Funds rate near zero.
However, as inflation climbed, they flipped and began modern history’s most aggressive interest rate hiking cycle.
The Federal Funds rate represents the overnight interest rate and shortest maturity rate. The Fed directly controls it, and the Fed has significant control across the maturity curve through its quantitative tightening (QT) and easing (QE) programs.
Quantitative Easing (QE) is a monetary tool central banks use to add money into the financial system by purchasing large quantities of financial assets, like bonds and securities, from commercial banks and other financial institutions. In contrast, Quantitative Tightening (QT) is the opposite process, where the central bank sells off these financial assets, effectively removing money from the economy to reduce the supply of money and increase interest rates.
The Fed’s balance sheet reflects QE and QT, which ballooned since the 2008 financial crisis and skyrocketed during the pandemic. However, it’s now drifting lower, arguably pulling liquidity out of the economy and tightening financial conditions.
Money primarily enters the economy through bank lending, which usually diminishes as interest rates rise faster on the shorter end of the maturity curve than the longer end, which happened as the Fed hiked the Federal Funds rate. The yield curve reflects this dynamic, which became significantly inverted.
Banks began significantly tightening their loan standards as the yield curve inverted and broad-based measures of the quantity of money in the financial system went negative on a % YoY basis.
However, liquidity entered the banking system recently through FHLB advances and other forms of shadow QE after several bank failures.
The main influences on interest rates are the economy’s expected growth, inflation rate, and fiscal and monetary intervention. Interest rates are also usually high when economic growth and inflation are high. The spread between interest rates and inflation is known as the real interest rate.
Real interest rates have been in secular decline since the 1980s and even negative in the last decade. When real interest rates are negative, capital often flows into speculative investments with payoffs far into the future instead of short-term profitable ventures.
But the big question is, “Where do we go from here.”
Downward pressure on commodities and labor costs occurred as globalization flourished. China’s economic rise and the former Soviet Union’s dismantling arguably put downward pressure on inflation over the last 30 years, stimulating technological innovation in the United States.
As free-trade and innovation increased, and China’s industrial base grew, manufacturing employment in the United States was hollowed out.
However, China’s working-age population is now peaking and will decline in the coming years.
China’s productivity growth put downward pressure on inflation and interest rates as they recycled profits into US treasuries. As this unwinds, interest rates and inflation can no longer have this downward pressure.
After the Soviet Union dissolved, a commodity surplus hit global markets. However, the geopolitical conflict in Russia could remove downward pressure on inflation as it’s one of the largest commodity-producing countries.
Government debt
As interest rates rise, interest expense on government debt increases. The government’s interest payments on its debt are now eclipsing spending on national defense.
US debt as a percentage of GDP is higher than when the world mobilized to fight a global war.
Although these measures seem unsettling, the US holds the reserve currency, and US debt is a safe-haven asset, which arguably allows it to get away with massive debt burdens.
Triffin’s Dilemma, refers to the double-edged sword faced by countries whose currency serves as the global reserve. Global economic stability requires the reserve currency country (e.g. the United States) to provide the world with a sufficient supply of its currency to facilitate international trade. This need often necessitates running large deficits. Running these deficits for too long can erode confidence in the value of the reserve currency, as it implies a growing level of debt and an increased supply of the currency. This dilemma, therefore, represents the tension between short-term domestic and long-term international economic objectives.
If the world is de-globalizing and free trade peaks, the United States’ ability to run large deficits could be questioned.
What if there’s a recession?
Market commentators have been predicting a US recession since the yield curve inverted and the Fed began an aggressive economic tightening cycle. However, a recession has yet to hit the economy. Historically, inflation and interest rates usually decline in a recession, but such declines are often short-lived as the economy recovers and a new wave of inflation takes hold. This volatility is impossible to predict but could have dire consequences for the future outlook of technological innovation.
Predicting the future of interest rates and investor appetite to fund speculative technological innovation is an inherently uncertain task.
A lower risk appetite could increase market volatility in an environment of rising interest rates. Furthermore, the financing of government debt, a significant factor in interest rate determination, is coming into question, adding another layer of complexity to the future trajectory of interest rates.
Regardless of economic volatility, I hope the prospect of what technological innovation unlocks far outweighs the potential of higher interest rates and inflation. The future is in our hands.
